There are tax benefits to be gained from your dependents—the dependency exemption, a dependent care flexible spending account, the child tax credit, and the credit for child and dependent care expenses.
The personal exemption has been eliminated, however, you may claim a dependency exemption for persons qualifying as your dependents.
For 2020, the standard deduction amount for an individual who may be claimed as a dependent by another taxpayer cannot exceed the greater of $1,100 or the sum of $350 and the individual’s earned income (not to exceed the regular standard deduction amount).
For 2020, the additional standard deduction amount for the aged or the blind is $1,300. The additional standard deduction amount increases to $1,650 for unmarried taxpayers.
Dependent Care Flexible Spending Accounts
You may contribute to your employer's dependent care flexible spending account if you have eligible dependent care expenses. Eligible expenses include the following:
Eligible expenses are for care provided so you are able to work. This does not include costs of babysitters you pay when you go out in the evening for pleasure.
Contributions to a flexible spending account are free from federal income tax and Social Security taxes. You pay your dependent care expenses and are reimbursed by the account. For each plan year, you estimate your dependent care expenses, and an equivalent pre-tax amount is deducted from your paycheck and deposited into your account. It is essential to estimate accurately, since any money in the account that isn't spent at the end of the plan year is forfeited. There is sometimes a grace period of 2½ months for submitting the expenses—you will need to check your flexible spending plan.
If you are married, you may contribute to this account as long as both spouses are employed outside the home, or one spouse is a full-time student (for at least five months out of the year) or disabled. Under most circumstances, you can contribute up to $5,000 ($2,500 if married filing separately) in pre-tax dollars to your account. Amounts are limited under certain conditions.
The IRS places limitations on the amount a "highly compensated" employee can contribute to a dependent care flexible spending account each year. The definition of "highly compensated" is adjusted annually by the IRS. If you will be limited during the year, your company benefits department will notify you. Any amounts contributed up to that point are available to you for pre-tax day care reimbursements. If you are highly compensated and your dependent care contributions will be limited, but your spouse is not highly compensated, use your spouse's dependent care flexible spending account (if available). An eligible dependent is defined as one you can claim on your tax return who is:
If you are divorced or separated and have custody of your dependent child, you may contribute to an account even if you have agreed to let your spouse claim a dependency exemption for the child.
For expenses to qualify, they must have been incurred for the purpose of allowing you or your spouse to work. Generally, if one spouse isn't working, no credit is allowed. Dependent care costs incurred while you are home ill and unable to work do not qualify. Expenses incurred while performing volunteer work are not considered eligible. However, expenses incurred while you are out looking for work do qualify.
Eligible childcare costs include those only for the actual care of your child, not costs for education, supplies, or meals, unless those costs cannot be separately stated.
If one spouse's wages are greater than the Social Security wage base for Medicare and the other spouse's wages are below the wage base, you should use the dependent care flexible spending account (if available) at the lower paid spouse's company, since you will save more Social Security taxes.
When you file your claim for reimbursement, you will be required to supply the name, address, and Social Security (or tax ID number) of the care provider. If you won't be able to provide this information, don't use a dependent care flexible spending account, since the favorable tax treatment afforded these accounts will be denied by the IRS.
Be careful about how much you put into your account. At the end of the plan year, you lose whatever money you have deposited into your account but don't use for dependent care. It should be easy to reasonably predict what your dependent care costs will be for the year. However, it is important to think about your circumstances for the entire year before you decide on an amount to contribute to the childcare flexible spending account. For example, perhaps you have an older child that could assist with child care in the summer. Paying your son or daughter would not qualify as an eligible expense, and you would not be eligible for reimbursement, because your child is your dependent in this example.
IMPORTANT NOTE: Remember, when using the dependent care flexible spending account that you'll contribute to the account with money that is deducted from each paycheck. At the same time, you'll be paying your child care expenses directly to your provider. In other words, you will pay twice for the care (once through the flexible spending account and once to your provider). You are then eligible for reimbursement when you submit your claims for day care expenses. You will need to plan accordingly. For example, if you pay your day care provider for the entire month on January 2, you will not be reimbursed for the total amount until the end of the month. You can, however, get reimbursed for a portion of the expenses as they are incurred.
Credit for Child and Dependent Care Expenses
Current IRS rules allow you to claim a tax credit for your dependent day care expenses of up to $3,000 for one dependent or up to $6,000 for two or more dependents. The criteria for establishing the eligibility of your dependent and the nature of the expense are the same as those for the dependent care flexible spending account.
Generally, the credit is 20% of expenses paid if your tax return adjusted gross income is more than $43,000. The credit increases to 35% when your adjusted gross income is $15,000 or less. The amount of the credit falls somewhere in between 20% and 35% for incomes between $15,000 and $43,000. Your credit may be limited if you're in the alternative minimum tax bracket.
You can save taxes on dependent care expenses either by claiming the tax credit on your federal income tax return or by participating in your employer's dependent care flexible spending account program. Both are intended to offer you tax savings. The best method for you depends on your income, the number of dependents you have and other factors. You can't duplicate expenses: either you take the credit, or you are reimbursed from your account with pre-tax dollars.
Which Way Is Best for You?
Let's look at some general guidelines:
If you have only one eligible dependent and you pay more than $3,000 in eligible childcare expenses, the dependent care flexible spending account may offer greater savings. This is because the credit for one child covers only $3,000 of expense while the account allows you to set aside $5,000.
If you are married, live together, but file separate tax returns, you are not eligible for the credit. You may still use the dependent care flexible spending account.
As a rule of thumb, if you are in the 25% tax bracket or above, you will likely receive a greater tax savings by using the dependent care flexible spending account. If you are in the 10% or 15% tax bracket, you are likely to be better off taking the dependent care credit.
The Child Tax Credit
Parents may claim a $2,000 credit against federal income tax for each child under age 17. In 2020 (same as in 2019) the credit is phased out starting from $400,000 of adjusted gross income for married joint filers and $200,000 for single filers.
The child credit is partly refundable; the refundable portion is referred to as the "additional child tax credit." You receive a refundable credit if your Child Tax Credit is greater than the total amount of income taxes you owe, as long as you had an earned income of at least $2,500 in 2020 (same as in 2019).